RETRACEMENTS REINFORCE MOVING AVERAGES - SHORT-TERM RATES MOVE AHEAD OF FED - RATES STILL LOW BY HISTORICAL STANDARDS - DOLLAR BENEFITS FROM RISING RATES - SWINGS WITHIN THE 2004 CORRECTION

RETRACEMENTS REINFORCE MOVING AVERAGES... This week John Murphy featured the S&P 500 and other global indices with the falling 50-day moving averages coming into play. Key Fibonacci retracements and short-term overbought readings are also coming into play. The Fibonacci Retracements Tool shows potential reversal/resistance levels based on three retracements: 38.2%, 50% and 62%. Keep in mind that these are not hard resistance or reversal levels. Instead, consider them potential reversal or resistance zones. After a sharp decline, we should watch closely when oversold bounces approach both the 50-day moving average and the 62% retracement mark, especially if these two are near each other. Charts 1, 2 and 3 show the Nasdaq 100 ETF (QQQQ), S&P 500 ETF (SPY) and Transport ETF (IYT) all nearing such zones. In addition, notice that the Stochastic Oscillator is trading above 80, which denotes an overbought condition. Momentum is both overbought and bullish when the Stochastic Oscillator holds above 80. A move below 80 would be the first sign that short-term momentum is weakening.

Chart 1

Chart 2

Chart 3

SHORT-TERM RATES MOVE AHEAD OF FED... With a quarter point hike in the discount rate, the Fed surprised some in the media, but few in the bond market. As one of the most interest rate sensitive asset classes, the bond market often moves before an actual Fed move. First, the Fed has been jawboning about the end of quantitative easing for some time now. Second, the Fed specifically mentioned the possibility of future rate increases last week, which was noted in the Market Message on Wednesday, February 10th. Third, interest rates have been moving higher since November. Yes, the bond market has been pricing in some sort of rate increase or tightening since November. Chart 4 shows the 3-month T-Bill Rate ($IRX) over the last 12 months. Short-term rates declined from March 2009 until November 2009. Rates bottomed in late November and moved higher the last three months. Short-term rates were moving higher well ahead of the Fed move.

Chart 4

DOLLAR BENEFITS FROM RISING RATES... The US Dollar Index ($USD) is shown in the indicator window in chart 4. Notice that the Dollar and short-term rates declined together from March to November. Also notice that the Dollar bottomed about the same time as short-term rates. There is a positive correlation at work here. Higher rates make Dollar denominated bonds more attractive. With the Fed signaling an end to crisis measures, easy money policies are slowly being reversed and this is positive for the Dollar. Combined with the debt crisis in Europe, the greenback is getting a double whammy of bullish news. Chart 5 shows the DB Dollar Bullish ETF (UUP) opening above 23.75 on Friday morning.

Chart 5

RATES STILL LOW BY HISTORICAL STANDARDS... The move from .25 to 1.00 may seem like a big move in percentage terms, but short-term rates are still extraordinarily low by historical standards. Also keep in mind that 1 on the chart is equivalent to a .10% yield (1/10th of 1%). Short-term rates are still essentially zero percent. In contrast, the 10-Year Treasury Yield ($TNX) currently yields around 3.79%. Chart 6 shows the 3-month T-Bill Rate plunging into early 2008 and then settling at the end of 2008. Short-term rates remains well below their pre-Lehman levels. The bottom window shows the 10-Year Treasury Yield (long-term rates) moving higher the first half of 2009 and then leveling out. Long-term rates are back near their November 2007 levels. Short-term rates are not even close. For short-term rates, it would take a break above the 2009 highs for a real vote of confidence.

Chart 6

FOCUSING ON THE 2004 CORRECTION... A number of readers ask for more insights into the 2004 correction for the S&P 500. Chart 7 shows the original chart from Wednesdays Market Message. The advance from March 2009 to January 2010 looks quite similar to the current advance. A 6-month correction followed the 2003 advance and I am looking at this correction for some potential guidelines on the future.

Chart 7

Chart 8 shows the S&P 500 ETF (SPY) for the corrective period from March 2004 until August 2004. It was one big zigzag lower. Each decline formed a lower low and each bounce formed a lower high. By early September 2004, the S&P 500 ETF (SPY) was trading at the same levels at March 2004 - six months prior. Even though it was a rather choppy correction, there were some pretty good swings within the correction. For upswings, the key was to look for a reversal after exceeding the prior low. For downswings, the key was to look for a reversal just below the prior high.

Chart 8

The indicator windows show the Stochastic Oscillator (20,5,5) with the MACD Histogram (5,35,5). These are not the default settings. I lengthened the Stochastic Oscillator settings to make the indicator less sensitive and shortened the MACD Histogram settings to make it more sensitive. The idea is to identify an upturn after an oversold reading. The blue arrows show the oversold readings. The blue dotted lines show the MACD Histogram turning positive, which means MACD moved above its signal line. Based on the indicators, there were five signals (two bad and three good).

Notice that this system utilizes two different momentum oscillators. The Stochastic Oscillator is bound by zero and one hundred, which makes it good for overbought and oversold readings. MACD is based on two moving averages, which is good to identify upturns. MACD (5,35,5) is not going to turn up until the 5-day moving average turns up. Because this system is using two momentum oscillators, its success is dependent on swing reversals every 1-2 months. This system would not be suited for strong trends, such as the 2003 and 2009 advances.